Life Insurance for Children

12/30/2008

Q: What do you think about the so-called "baby/children" whole life insurance policies that parents, grandparents and guardians receive in the mail? -- MF via email

A: They're a sad waste of money.

Life insurance is a terrific way to replace your income for your dependents. There's no reason to buy it for a child unless he's supporting the family.

Parents can best protect a child with life insurance by getting bigger policies on their own lives. Both parents should be covered, says Richard Freeman, a principal and certified insurance consultant at Round Table Financial Services in Westport, Ct. If Dad's an investment banker and Mom's home with the kids, her policy shouldn't just cover the cost of a nanny to replace her, he adds. It should be big enough to let Dad take a job with shorter hours closer to home, so he can have time with the kids if he's the surviving parent.

The sales pitch for life insurance on a child is that the policy guarantees him the right to buy more coverage without a medical exam. If he develops health problems later in life, this far-sighted purchase could be only way he'll qualify for coverage! The reality: Very few people are rejected for life insurance anymore. Thanks to medical science, you can live for years with diseases that would once have killed you. Even people who've had cancer or a heart attack are no longer uninsurable. (Remember, we're talking life insurance, not health or disability coverage.)

Another pitch is that the policy is a tax-sheltered investment for the child's college education. The reality: Life insurance is an expensive, inefficient way to save for a child. Your investment options in the policy are limited and overpriced, and a big chunk of your money goes to the insurer's marketing costs. And your earnings are taxable as ordinary income when you withdraw them.

Let's say you put $5,000 into a policy, and it's worth a little over $10,000 by the time Junior goes to college. You can withdraw $5,000 tax-free because i's a return of principle. You can take another $5,000 as a tax-free policy loan. But if you terminate the policy -- i.e., stop paying premiums -- the $5,000 loan immediately becomes a taxable withdrawal, says Freeman. To avoid the tax, you must maintain the policy until you die.

A 529 plan or a Coverdell Savings Account are much better savings vehicles. A Coverdell can be used for expenses from kindergarten through college. A 529 plan is only for college. Earnings in both accounts are tax-free when spent on eligible expenses. If the child named as the account beneficiary doesn't have educational expenses, you can use the Coverdell or the 529 account to pay for another family member's education. (Earnings spent on non-educational costs are subject to taxes and a 10% penalty.)

In a Coverdell, you have virtually unlimited investment options; the accounts are available at any bank, mutual fund, or brokerage. You can deposit up to $2,000 a year, depending on your income. Contribution limits gradually decline for single taxpayers with income between $95,000 and $110,000 and married couples with income between $190,000 and $220,000.

A 529 plan has no income requirements or annual contribution limit. Each plan offers its own menu of mutual funds. New York's 529 plan funds are managed by Vanguard Group, a first-rate, low-cost provider. State residents who are single taxpayers can deduct up to $5,000 of annual 529 contributions from their New York income taxes; couples can deduct up to $10,000 a year.